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Here's What You Need To Worry About From High-Frequency Trading

Yes, even if you're a long-term investor, you still need to be aware of the risks behind high-frequency trading.

Ever since the meltdown at Knight Capital(NYSE: KCG) earlier this month, the debate over high-frequency trading has exploded.

In short form, high-frequency trading is a flavor of trading that leverages computers and the speed of super-fast data connections to make lightning-quick trades, and lots of them. This means that, often, the trader's servers are situated in the same data center as the exchange's servers. While there's no single strategy of a high-frequency trader -- they might be acting like a market maker, or playing index arbitrageur -- the common thread is that they all rely on speed to succeed.

So, the $1 trillion question (inflation is brutal) is: Is this type of trading a major risk for markets, or closer to a non-factor?

Earlier this month, an animated graphic made rounds that many commentators pointed to as clearly showing that high-frequency trading is in the process of blowing up markets. I countered that the graphic showed the growing presence of high-frequency trading, but didn't necessarily show whether or how that presence was bad for the markets. Yesterday, my fellow Fool Brian Stoffel took that one step further and called high-frequency trading "just a lot of noise," and concluded that "It's either a positive or a complete non-factor for individual, buy-to-hold investors."

One of the biggest problems we face with figuring out whether high-frequency trading is good, bad, or neutral for long-term investors is that there's much that's unknown about the trading, who's doing it, and for what purpose. Why that is will become clearer in just a moment.

To Brian's point, there's an argument that, for long-term investors, the issue of high-frequency trading isn't something to lose sleep over. At the end of the day, if you're buying a piece of a company to own it for a long period of time, your primary concern should be the dynamics of the business, not the technical stock-market action. Most Fool readers have likely heard the Warren Buffett quote: "I buy on the assumption that they could close the market the next day and not reopen it for five years."

Great, but do we want the market shut down?Keeping in mind the fact that we're ideally buying companies and not stocks, we should still want a healthy, properly-functioning market that allows us to transact. And there are some signs that high-frequency trading is doing a lot to gum up the markets and cause some serious problems.

Led by founder Eric Hunsader, the folks over at market-data collector Nanex -- the creator of the now-famous high-frequency trading GIF -- have been on a warpath against bad practices among high-frequency traders. Specifically, they're very concerned about the proliferation of quotes by high-frequency traders.

When you log onto, say, E*Trade(Nasdaq: ETFC) to make a trade, what you see listed under the bid and ask are quotes -- that is, somebody offering to buy or sell at a certain price. In the normal course of a trader's day, he'll end up putting out lots of quotes, and cancelling many of them. Why? Because he may quote a certain price, see a couple of trades take place, and decide that the stock is moving, and so it's a good idea to cancel the previous quote and put in a new bid or offer at a different price.

As the high-frequency trading industry has grown, though, the number of quotes has exploded – and, mind you, we're talking just quotes here, because actual trading has not grown anywhere near as much. The reason that high-frequency traders are putting out this many quotes isn't entirely clear. In some cases, it may simply be offering and cancelling quotes the same way any market maker would;, but in other cases, it may be programs sending out odd quotes in an effort to mislead other market participants -- think Muhammad Ali pulling a rope-a-dope. In some cases, Nanex has even proposed that high-frequency traders send out a barrage of quotes to create a sort of informational fog of war that gives them a brief trading edge over other participants.

The problems created by this quoting aren't just in the abstract. Here are a few concrete potential outcomes from this flood of quotes:

Cost. Exchanges and brokers need to process, manage, and store market data, so as the volume of quoting activity rises, that increases the data-processing burden. Exchanges like NYSE Euronext(NYSE: NYX) and Nasdaq OMX(Nasdaq: NDAQ) have to keep up with this, as do brokers like E*Trade and TD Ameritrade(Nasdaq: AMTD). That means costly servers, routers, switches, and storage devices. While computerized trading has done much to reduce the cost of trading, there's a concern that this data overload threatens to reverse that trend.

Scaring away liquidity. High-frequency, and many other types of traders are, understandably, reluctant to trade when they believe they're getting a bad data feed. When a rush of quotes hits the market, it has the potential to slow everything down, create corrupted feeds, and cause liquidity providers to bow out. Nanex believes that this exact scenario played out during the Flash Crash. It's also a contributor to the 10,693 "micro-flash crashes" -- super-fast bursts of erratic trading -- that Nanex has identified so far this year.

Figuring out what the heck is going on. In the wake of the Flash Crash, it took regulators months to put together the forensic trading data from just a single day. Technology is clearly a boon to the markets but, when things go wrong -- and they will, regardless -- it's essential that we have a system that regulators can quickly and easily navigate.

The disappointing answerIt'd be nice if there were an easy, pat answer to this issue like "ban high-frequency trading" or "high-frequency trading is a non-issue." Unfortunately, there's not.

What we need is for regulators to dig into the problem, figure out what's going on -- who's playing by the rules and who isn't -- and set rules that will allow us to take advantage of the latest technologies in the financial markets without the threat from ne'er-do-wells who abuse those technologies. To be sure, this is already happening -- the SEC recently approved a plan for a consolidated audit trail that would help it monitor markets, and it's holding a round-table on technology and automated market systems next month.

Fool contributorMatt Koppenhefferowns shares of E*Trade, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting hisCAPS portfolio, or you can follow Matt on Twitter@KoppTheFoolorFacebook. The Fool’sdisclosure policyprefers dividends over a sharp stick in the eye.